Investment Management
AUGUST 2003
CFTC Adopts Major Relief from CFTC Registration
Requirements for Mutual Funds, Hedge Funds and
Investment Advisers
At a time when participants in U.S. securities
markets face increasingly onerous regulatory
burdens, the Commodity Futures Trading
Commission (“CFTC”), on August 4, 2003, adopted
rules that (1) expand the ability of registered
investment companies (“RICs”) to use futures and
commodity options without regulation as commodity
pool operators (“CPOs”) and (2) lessen the
registration and other regulatory requirements
applicable to hedge fund operators, investment
advisers and others who trade in futures and
commodity options. In particular, the new rules:
n
Eliminate CFTC limitations on futures and
commodity options trading activities by RICs,
including RICs that invest in unregistered
hedge funds.
n
Create exemptions from CFTC registration for
persons who operate hedge funds, including an
exemption permitting unlimited futures and
commodity options trading activities for many
3(c)(7) funds and a more limited exemption for
many 3(c)(1) funds.
n
Clarify that operators of hedge funds-of-funds,
in determining compliance with a new CFTC
registration exemption that includes a trading
limitation, may rely on the representations of
underlying fund managers.
n
Create new exemptions from CFTC
registration for investment advisers who advise
RICs and hedge funds.
BACKGROUND
The federal statute governing commodity trading is
the Commodity Exchange Act. The CFTC is the
federal agency that enforces the Commodity
Exchange Act and issues regulations to implement its
provisions. Persons required to register as
commodities professionals under the Commodity
Exchange Act also must become members of the
National Futures Association (“NFA”), a commodity
self-regulatory organization designated by the CFTC.
Definitions. Investment advisers and other money
managers commonly fall within two regulatory
classifications under the Commodity Exchange Act:
commodity trading advisors (“CTAs”) and/or CPOs.
The Commodity Exchange Act generally defines a
CTA broadly to include any person who (i) advises
others, for compensation or profit, as to the
advisability of trading in domestic exchange-traded
futures contracts or commodity options that are
regulated by the CFTC (such futures and commodity
options being referred to herein as “futures” and
“commodity options,” respectively), or (ii) as part of
a regular business issues analyses or reports
concerning such instruments. The definition of CTA
thus encompasses not only persons whose primary
business is to provide futures and commodity options
trading advice, but also persons, such as investment
advisers and banks, that provide futures and
commodity options trading advice to their clients in
connection with their general business of providing
securities trading advice.
Kirkpatrick & Lockhart LLP
Similarly, the term CPO is defined very generally in
the Commodity Exchange Act to include any person
who pools client money for the purpose of trading in
futures or commodity options. The definition covers
persons who manage traditional commodity pools, as
well as persons who, for example, operate RICs,
hedge funds and bank collective funds that trade in
futures or commodity options.
Registration and Relevant Exemptions. Unless
they are able to claim an exemption from
registration, CPOs and CTAs are required to register
with the CFTC and the NFA prior to acting as a CPO
or CTA. Registration entails the completion of
various forms using the NFA’s new online
registration system. The principals of the CPO or the
CTA are subject to extensive background checks and
are required to have passing scores on one or more
examinations.
The CFTC rules contain several exemptions and
exclusions from CPO and CTA registration
requirements. On October 28, 2002, November 6,
2002 and March 17, 2003, the CFTC proposed to
expand the available exclusions and exemptions and,
in some cases, included no-action relief allowing
immediate reliance on the proposed rules. The
CFTC adopted final rules on August 4, 2003, as
discussed further below.
RULE 4.5: FUTURES AND COMMODITY
OPTIONS TRADING ACTIVITIES BY RICS AND
OTHER REGULATED ENTITIES
Background. Rule 4.5 excludes from the definition
of CPO persons that operate pools that are regulated
by some other regulatory authority. The following
persons, and principals and employees thereof, are
eligible to rely on Rule 4.5:
n
RICs,
n
Insurance companies subject to state
regulation,
n
Banks, trust companies and other financial
depository institutions subject to federal or
state regulation, and
n
Trustees of, named fiduciaries of, and
employers maintaining a pension plan that is
subject to Title I of the Employee Retirement
Income Security Act of 1974, as amended
(“ERISA”).
Each person listed above is excluded from the
definition of CPO with respect to the operation of
their respective “qualifying entities.” For a RIC, the
qualifying entity is the RIC itself; for insurance
companies, it is an insurance company separate
account; for banks, trust companies and other
financial depository institutions, it is the assets of any
trust, custodial account or other separate unit of
investment for which the bank is acting as a fiduciary
with investment authority; and, for trustees of
pension plans, it is a pension plan subject to Title I of
ERISA.
In the RIC context, Rule 4.5 operates to exclude the
RIC from CPO registration. However, a RIC’s
adviser and sub-advisers would still be CTAs and
need an independent exemption from CTA
registration. As discussed further below, CFTC Rule
4.14(a)(8) contains such an exemption but only for
CTAs whose advice is directed solely to RICs or
other specified entities.
Prior Trading Limitations. To take advantage of
the exclusion provided by Rule 4.5, the persons
listed are required to file a notice with the CFTC and
the NFA. Previously, this notice required the person
to represent that it would operate the related
qualifying entity in compliance with a limitation on
the use of futures and commodity options for other
than bona fide hedging purposes. The qualifying
entity was required to represent that it would limit
the aggregate initial margin and premiums required
to establish any such non-bona fide hedging
positions to 5% of the liquidation value of the
qualifying entity’s portfolio, after taking into account
unrealized profits and unrealized losses on any such
contracts into which it had entered.
On October 28, 2002, the CFTC proposed an
amendment to Rule 4.5 that would have created a
new “Notional Test” for other than bona fide hedging
positions, on which a qualifying entity could have
relied as an alternative to the 5% test. Under the
proposed Notional Test, a qualifying entity would
have been required to represent that the aggregate
“notional value” of its non-bona fide hedging futures
and commodity options positions does not exceed the
liquidation value of its portfolio, after taking into
account unrealized profits and unrealized losses on
any such contracts it has entered into. The October
28, 2002 proposing release included no-action relief
permitting reliance on the Notional Test pending
adoption of the final rule.
Kirkpatrick & Lockhart LLP
2
Elimination of All Trading Limitations. As
adopted, Rule 4.5 eliminates both the 5% test and
the Notional Test. Thus, there are now no CFTC
limitations on the use of futures or commodity
options by qualifying entities. Among other things,
this change makes it much easier to operate
registered funds-of-funds whose underlying funds
trade futures or commodity options. However, the
ability of qualifying entities to use futures or
commodity options may still be limited under other
applicable laws and regulations, such as Section 18
of the Investment Company Act of 1940, as
amended (“1940 Act”), in the case of RICs.
Additionally, amended Rule 4.5 no longer contains
the requirement that a qualifying entity not be
marketed to the public as a commodity pool.
However, qualifying entities are now required to
disclose in writing to each participant that the
qualifying entity is operated by a person who has
claimed an exclusion from the definition of CPO
under the Commodity Exchange Act and, therefore,
is not subject to registration or regulation as a CPO.
For a RIC, this disclosure should be contained in its
prospectus or statement of additional information.
RULE 4.13: EXEMPTIONS FROM CPO
REGISTRATION FOR POOLS WITH
SOPHISTICATED INVESTORS
Exemption Requiring Lower Sophistication with
Trading Limitation. New CFTC Rule 4.13(a)(3)
exempts a CPO from registration if, among other
conditions:
n
interests in the pool are exempt from
registration under the Securities Act of 1933,
as amended (“Securities Act”), and such
interests are offered and sold without
marketing to the public in the United States,
n
it restricts participation in the pool to
(i) “accredited investors” as defined in Rule
501 under the Securities Act, (ii) certain
family trusts formed by accredited investors,
(iii) “knowledgeable employees” as defined in
Rule 3c-5 under the 1940 Act and (iv) the
CPO itself and certain other employees and
affiliates of the CPO who are “qualified
eligible persons” (“QEPs”) as defined in
CFTC Rule 4.7(a)(2)(viii)(A),
n
at all times it limits the commodity interest
positions (whether or not entered into for bona
fide hedging purposes) in each of its pools
such that either (i) the aggregate initial margin
and premiums required to establish such
positions will not exceed 5% of the liquidation
value of the pool’s portfolio, after taking into
account unrealized profits and losses, or
(ii) the aggregate “net notional value” of such
positions, determined at the time the most
recent position was established, does not
exceed 100% of the liquidation value of the
pool’s portfolio, after taking into account
unrealized profits and losses, and
n
the CPO does not market participations in the
pool to the public as a commodity pool or
otherwise as or in a vehicle for trading in the
futures and commodity options markets.
Qualifying entities remain subject to all relevant
provisions of the Commodity Exchange Act and
CFTC rules that apply to all commodity interest
market participants, such as the general antifraud
rules, the prohibitions on manipulation and the trade
reporting requirements. In addition, qualifying
entities relying on Rule 4.5 must continue to make a
filing with the CFTC and the NFA.
Ramifications. Now that the CFTC has eliminated
all trading limitations under Rule 4.5, RICs should
consider whether they should amend their
prospectuses, statements of additional information
(“SAI”) and, if applicable, fundamental or nonfundamental investment restrictions to reflect the
expanded permitted use of futures and commodity
options. New notices do not need to be filed with
the CFTC or the NFA. However, if a RIC or other
qualifying entity wishes to rely on the new rule (and
eliminate any CFTC-related limitation on the use of
futures and commodity options), it must amend its
disclosures to comply with the new rule’s
requirements.
Kirkpatrick & Lockhart LLP
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Exemption Requiring Higher Sophistication with
No Trading Limitation. New Rule 4.13(a)(4)
exempts a CPO from registration if, among other
conditions:
n
interests in the pool are exempt from
registration under the Securities Act and such
interests are offered and sold without
marketing to the public in the United States,
and
n
it restricts participation in the pool to natural
persons who are QEPs as defined in CFTC
Rule 4.7(a)(2) and non-natural persons who are
either QEPs or “accredited investors” as
defined in Rule 501(a)(1)-(3), (a)(7) or (a)(8).
This adopted exemption, unlike that adopted in Rule
4.13(a)(3), does not impose any limitations on
futures and commodity options trading activities,
ostensibly because the QEP sophistication standard
for natural persons in Rule 4.13(a)(4) is higher than
the sophistication standards in Rule 4.13(a)(3).
It is significant that the exemption in Rule 4.13(a)(4)
applies only to pools with natural persons who are
QEPs by virtue of Rule 4.7(a)(2) and not also Rule
4.7(a)(3). In general, a natural person can be a QEP
under Rule 4.7(a)(2) by being a “qualified
purchaser” as defined in the 1940 Act, a
“knowledgeable employee,” a Non-United States
person, as defined in CFTC Rule 4.7(a)(1)(iv), or the
CPO itself and certain other employees and affiliates
of the CPO. By contrast, Rule 4.7(a)(3) contains a
lower QEP eligibility threshold ($2,000,000 in
investments as compared to the $5,000,000 required
to attain qualified purchaser status). Thus, CPOs of
most “qualified purchaser” Section 3(c)(7) hedge
funds could in theory comply with the Rule
4.13(a)(4) exemption.
Non-U.S. investors are typically QEPs by virtue of
being “Non-United States persons” under CFTC
Rule 4.7(a)(1)(iv). Accordingly, an offshore hedge
fund that does not have any U.S. investors who are
natural persons should also be able to qualify for the
Rule 4.13(a)(4) exemption.
Notice and Disclosure. The CFTC release notes
that a pool operator could simultaneously operate a
pool that relies on the exemption in Rule 4.13(a)(3)
and one that relies on the exemption in Rule
4.13(a)(4). A registered CPO may also rely on these
rules. For example, a CPO may operate a pool in
compliance with Rule 4.13(a)(4) to avoid some of
the periodic reporting requirements that are
ordinarily applicable to a CPO’s commodity pools.
To avail itself of the exemption in either Rule
4.13(a)(3) or (a)(4), the CPO must file a prescribed
notice with the NFA. In addition, it must disclose to
each prospective participant in the pool: (1) a
statement that the person is exempt from registration
as a CPO and, unlike a registered CPO, is not
required to deliver a disclosure document and a
certified annual report to participants in the pool, and
(2) a description of the criteria pursuant to which it
qualifies for an exemption from CPO registration.
The rule also contains certain recordkeeping and
annual report requirements, and persons who rely on
the rule are subject to special calls by CFTC staff.
Persons who already claimed relief under the prior
no-action position do not need to refile their claim.
If, however, a person wishes to take advantage of the
expanded relief, compliance with the revised
disclosure requirements is required.
APPLICATION OF RULE 4.13 TO FUNDS OF
FUNDS
The CFTC adopted a new Appendix A to Part 4 of
the CFTC rules to address the application of the Rule
4.13(a)(3) trading limits in the context of “funds-offunds” (“FOFs”). Many CPOs operate commodity
pools that do not invest directly in futures and
commodity options but instead invest in one or more
underlying funds that themselves trade in futures and
commodity options. FOFs may invest in a dozen or
more underlying funds and the operator of the FOF
often has no affiliation with the operators of the
underlying funds, thus raising the issue of how a FOF
operator would determine compliance with the 5% or
100% limitation in Rule 4.13(a)(3).
Appendix A generally provides that a FOF may rely
on the representations of underlying funds in
assessing the FOF’s compliance with Rule
4.13(a)(3). For example, if a FOF invests
exclusively in underlying funds that themselves
comply with the trading limitation in Rule 4.13(a)(3),
then the FOF itself would comply with the trading
limitation in Rule 4.13(a)(3). Similarly, a FOF may
comply with Rule 4.13(a)(3) by obtaining contractual
assurances from its underlying funds regarding the
futures and commodity options trading activities of
the underlying funds and aggregating the percentage
limitations to determine the FOF’s compliance with
Kirkpatrick & Lockhart LLP
4
the 5% or 100% limitation. Appendix A does note,
however, that FOF operators must still comply with
all of the other requirements of Rule 4.13(a)(3) to
avail themselves of the exemption from CPO
registration.
RULE 4.14: EXEMPTIONS FROM CTA
REGISTRATION
Prior Rule 4.14(a)(8). Prior CFTC Rule 4.14(a)(8)
exempted from registration CTAs that gave
commodity interest trading advice solely to Rule 4.5
qualifying entities, and were registered as investment
advisers with the SEC or excluded from the
definition of investment adviser under the Investment
Advisers Act of 1940, as amended (“Advisers Act”),
pursuant to Section 202(a)(2) or Section 202(a)(11)
(this exclusion includes certain banks, lawyers and
other professionals, brokers, dealers and publishers).
The prior Rule did not exempt smaller investment
advisers (those with under $25 million in assets
under management) that were registered with a state
securities regulator and not with the SEC.
Adopted Rule 4.14(a)(8). Amended Rule 4.14(a)(8)
expands the CFTC exemption to cover U.S. stateregistered investment advisers and investment
advisers that are exempt from federal and state
registration.
In addition, amended Rule 4.14(a)(8) extends the
exemption to CTAs whose futures and commodity
options trading advice is directed solely to (and for
the sole use of):
n
CFTC Rule 4.5 “qualifying entities” for which
notices of eligibility have been filed or that are
excluded from the definition of the term
“commodity pool” in CFTC Rule 4.5(a)(4),
n
CPOs that have claimed an exemption from
registration under CFTC Rules 4.13(a)(3) or
4.13(a)(4), or
n
commodity pools organized and operated
outside of the United States that meet the
following conditions:
o
The CPO has not organized and is not
operating the pool for the purpose of
avoiding CPO registration;
o
With the exception of the pool’s operator,
advisor and their principals, only “NonUnited States persons” (as defined in CFTC
Rule 4.7(a)(1)(iv)) may contribute funds or
other capital to, and own beneficial interests
in, the pool; provided that units of
participation in the pool held by persons
who do not qualify as Non-United States
persons or as QEPs may not represent 10%
or more of the beneficial interests in the
pool;
o
No person affiliated with the pool may
conduct any marketing activity for the
purpose of, or that could reasonably have
the effect of, soliciting participation from
other than Non-United States persons; and
o
No person affiliated with the pool may
conduct any marketing activity from within
the United States, its territories or
possessions.
To qualify for the exemption, a CTA also must limit
its commodity interest trading advice to that which is
“solely incidental” to its business of providing
securities or other investment advice to the trading
vehicles specified in the Rule, and it must not hold
itself out as a CTA. A prescribed notice must also be
filed with the NFA. The Rule also contains certain
recordkeeping requirements, and persons who rely on
the Rule are subject to special calls by CFTC staff.
Persons who already claimed relief under the prior
no-action position do not need to refile their claims.
TREATING AN ENTITY AS A SINGLE CLIENT
Section 4m of the Commodity Exchange Act
provides that the registration requirements for CTAs
do not apply to any CTA who, during the course of
the preceding 12 months, has not furnished
commodity interest trading advice to more than
15 persons and who does not hold itself out generally
to the public as a CTA. For purposes of determining
the number of persons a CTA advises, the CFTC staff
has long interpreted the statute to require CTAs to
“look through” any entities they advise (such as
partnerships or corporations) and to count each
limited partner, shareholder or other investor as a
“person” advised by the CTA.
As adopted, Rule 4.14(a)(10) eliminates this “look
through” position. Under this Rule, any entity
advised by a CTA that receives commodity interest
trading advice based on its investment objectives,
rather than on the individual investment objectives of
its investors, would count as only one “person” for
purposes of determining eligibility for the exclusion
from registration under Section 4m of the
Commodity Exchange Act. This position is
analogous to the current treatment of entities as a
Kirkpatrick & Lockhart LLP
5
single client under Rule 203(b)(3)-1 under the
Advisers Act. Indeed, the CFTC stated in the
adopting release that it generally intends to follow
the SEC’s interpretations of Rule 203(b)(3)-1.
Ironically, however, there is speculation that the SEC
may soon change Rule 203(b)(3)-1 to look through
entities.
The CFTC’s release does not discuss whether pools
that are excluded or exempt from CPO registration
pursuant to Rule 4.5 or Rule 4.13 should be counted
as “persons” advised for purposes of determining
compliance with the “15-person” limitation. As
adopted, Rule 4.14(a)(10) does not alter the
additional statutory prerequisite of Section 4m—that
a CTA not hold itself out generally to the public as a
CTA.
OTHER ADOPTED RULES
The CFTC also adopted rule changes that (1) permit
CTAs and CPOs to engage in certain types of
communication with investors prior to distribution of
a required disclosure document, (2) establish criteria
for CPOs to distribute periodic account statements
electronically, (3) harmonize the various signature
requirements of Part 4 of the CFTC rules, (4) provide
relief from some of the duplicative disclosure and
reporting requirements in the master-feeder context,
and (5) provide guidance regarding the presentation
of past performance information.
CARY J. MEER
202.778.9107
cmeer@kl.com
MARC MEHRESPAND
202.778.9191
mmehrespand@kl.com
Kirkpatrick & Lockhart LLP
6
Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related
specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal
counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund
complexes. No law firm was mentioned more frequently in the Scorecard.
We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement
plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly
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variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
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We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
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WASHINGTON
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.